A Real-Life Lesson in Value Traps

Offshore drillers have taught me how not to value invest

The offshore drilling industry is one I have been following for some time; not as an investor, but as a student of value.

This industry appeared to offer lots of value when the price of oil first began its descent in 2014. At the time, it looked as if decline would be temporary and drillers, with backlogs lasting years, would be able to weather the downturn.

Nearly four years in and much has changed. Oil majors have slashed capital spending, and drillers have paid the price. Assets have been written down, contracts canceled and backlogs eliminated thanks to actions by shareholders to try and offset a liquidity event.

Unfortunately, there have been many casualties as a result of this turmoil. The biggest is Seadrill Ltd. (NYSE:SDRL), formerly the largest company in the sector with the biggest and most advanced fleet, which was forced to seek protection from its creditors and equity holders have been wiped out. With asset values falling, the company's debt spiraled out of control and interest repayments overwhelmed the company as contracts were canceled.

The industry’s whole slump is a warning to value investors about the dangers of value traps. Since the beginning of 2015, almost every driller has, at one point or another, looked attractive based on price-book ratio (less than one), but the value has never come through (so far at least).

As a result, all of the drillers have become value traps. There are several key takeaways from this scenario, which combine to form a mini list of value trap qualities.

First, the drillers had bloated balance sheets. Pre-crash, the demand for offshore rigs and drillships was at an all-time high. The high price of oil coupled with cheap credit meant explorers were rushing to find new resources and drillers could buy new drilling units on cheap credit to meet rising demand. This pushed prices for rigs and drillships higher, inflating the companies' balance sheets.

Second, drillers had become reliant on debt to fund expansion. Companies were borrowing heavily to finance the expensive construction of new rigs hoping demand would continue at elevated levels and they would be able to pay off the balance. They were betting on a future no one could foresee.

Third, the drillers are essentially at the bottom of the value chain. They have no pricing power whatsoever. The companies have to take prices from the oil exploration companies (customers) and construction yards who supply the rigs. The liability for an unused, unsellable rig falls entirely on the operator. If they cannot sell it, they are stuck with the asset and the debt used to fund it.

The value trap factors

The following three factors make a toxic combination:

Asset values at a cyclical high, inflating the size of the balance sheet.

Weak balance sheets.

A lack of pricing power.

You can extrapolate these factors to any company to see if it is a value trap. Unsurprisingly, the companies that refused to partake in the debt-fueled expansion with strong balance sheets have survived.

Rowan Companies (NYSE:RDC) and Transocean (NYSE:RIG) are, ironically, the highest valued companies in the sector today (on a price-book basis) even though they were the cheapest before the crisis.

While investors shunned them before the downturn due to their lack of growth, they are now attractive as a result of their conservative balance sheets. Acquisitions are also on the table. Rowan is in talks to acquire the drilling business of A.P. Moller Maersk AS (OCSE:MAERSK A) and, in August, Transocean agreed to acquire Songa Offshore (FRA:SOY) for $3.4 billion.

The key takeaway from all of this: If you are looking for value, the most conservatively run companies will not let you down.

Disclosure: The author owns no stocks mentioned.

About the author:

Rupert Hargreaves

Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. Prior to his investing and writing career, Rupert was as a proprietary currency trader. Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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